Why Dollar Cost Averaging Makes Sense

After The Big Money ran its silly attack on Suze Orman, it was criticized for its ignorant take on dollar cost averaging, and the editor, Jim Ledbetter, promised to "run a piece on the dollar cost averaging investment strategy in the coming days". The piece has now appeared, and has managed to achieve the remarkable feat of making The Big Money wrong on DCA twice, for two different and opposite reasons.

The question here is simple: if you want to build up a stock portfolio as a long term investment, what's the best way to do so? The answer is equally simple: slowly, steadily, one piece at a time. Each month, take a fixed dollar amount, and invest it in stocks. Eventually, you'll have lots of stocks.

The DCA argument is that going about saving for retirement in this manner makes a lot of sense, because if you're spending a fixed dollar amount each month, then you buy more stocks when they're cheap, and fewer stocks when they're expensive. (Right now, for instance, $1,000 would buy you 107 shares of General Electric, whereas it would have bought you just 29 shares a year ago.)

The Big Money has attacked this idea from two different directions. First was James Scurlock:

It is not Suze's hypocrisy or even her intellectual laziness that really bothers me; no, that would be something Suze "loves" called "dollar cost averaging," which involves buying the same stock over and over again as it falls. "It's a great opportunity for you when the value of the shares drops," claims Suze in the inaptly named The Road to Wealth, "because you can buy shares at 'bargain' prices and average down your cost per share." Oh, where to begin? Maybe with the obvious: Since when does throwing good money after bad make you rich?

Scurlock's problem here is that if you buy stocks when stocks are falling, then you lose more money than if you don't. Well, yes. But this implies some kind of market-timing strategy: it seems he would rather sell at the top. Wouldn't we all. Pity no one can really do that. As Justin Fox says, DCA

is basically the only rational approach for those who (a) think the stock market is a good long-run investment and (b) can't reliably predict its short- or even its medium-term movements. Category (b) takes in the vast majority of investors. Category (a) has been losing a lot of adherents lately, but that's sort of the point. Sticking to a regime of dollar cost averaging forces one to keep putting money into the market when it is most unfashionable, which happens to be exactly when one should be putting money into the market.

In the site's second article on DCA, Scurlock's criticism is nowhere to be found. Instead, Karim Bardeesy offers up this:

The mathematical "proof" that DCA is "suboptimal" was given by University of Chicago business professor George Constantinides in 1979. "Replacing one major gamble on a temporary shift of prices by a number of smaller gambles" doesn't necessarily work, especially if you remember that dollar-cost averaging cuts both ways--that there are occasions when cash is actually more valuable than a potential stock investment. (See a layman's walk-through of Constantinides' argument here.) Subsequent data-driven research showed that, under a variety of different actual historical time horizons, taking that big gamble up front worked better over the long haul.

Bardeesy, here, is saying that if you want to invest a big lump sum in stocks, then go ahead and invest the big lump sum into stocks: you'll be better off than if you trickle it into stocks slowly, over time. This strategy is even more susceptible to Scurlock's criticism than DCA: if there's a big stock-market fall, you won't throw good money after bad, because you'll have blown all your money in one big gamble already.

But more importantly, Bardeesy completely misses the point of DCA, which is to construct a way of building up a substantial nest egg over time: it's not designed for people who have a substantial nest egg to begin with. "The idea behind DCA," says Bardeesy, "is that you take a batch of mattress-ready money and move into the stock market in installments over a set period of time, rather than all at once". No! DCA is for real, normal, people, who like an easy and simple way to invest over time. It's not for trust-fund babies who are wondering how to invest their inheritance.

The genius of DCA is that it makes it easy to get over the psychological barriers to investing in down markets, when stocks are cheap. So it's a very good idea. What's more, if you do happen to be lucky to have a lump sum right now, maybe dipping your toe gently into the stock market using a DCA-like strategy might be the only way you'd be willing to buy stocks at all. Which means that, by Constantinides's argument, you'd be better off using DCA than doing nothing.

So go ahead and keep on investing in stocks, if that is what you've been doing all along. If it made sense at Dow 14,000, it surely makes much more sense at Dow 7,500.